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Exam January 2015 Questions and Answers - First Part
Financial Institutions and Banking (Universiteit van Amsterdam)
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1. The global financial crisis that started in 2007 has
many features in common with crises that occurred
over the past 2-3 decades. Which factors made this
crisis more violent than the previous ones, and how
did they work?
•
The global financial crisis can be viewed as the unwinding of
global financial imbalances accumulated in the preceding
years. It is a manifestation of boom-bust cycles in the
financial system typical for system-wide financial crises.
•
Changes in the macroeconomic environment, in policy
frameworks and in the financial system, which happened on a
global scale before the crisis, contributed to making the boom
more pronounced and the bust more violent.
•
On the macro side, the decades before the crisis saw the
Great Moderation, a period of strong productivity growth,
strong and stable output growth, and low and stable inflation.
This can be explained by structural changes (the advent of
China on the global stage, innovation in production
processes, deregulation) etc. and by “ good luck”.
•
On the policy side, central banks success in taming inflation
by more focusing more on inflation, more transparency and
independency, was important. Also, deregulation in the
financial sector and an emphasis on market evaluations
(credit rating agencies, mark-to-market, etc) was important.
•
During the boom phase, financial institutions tended to take
on what with the benefit of hindsight can be viewed as
excessive risk.
•
This excessive risk taking was fostered by two financial
innovations: securitization (which grew in the 1990s) and
structured finance (which grew very fast in the 2000s).
a. Securitization, a process of pooling of various types of debt
(mortgages, auto loans, etc) and selling the consolidated
debt to investors.
b. In this process, a key role is played by structured finance, a
sector of financial system created to help transfer risk and
respond to regulation by designing complex legal and
corporate entities. The typical feature of this is special
purpose vehicles, created to use assets originated
by/obtained from a sponsoring firm to support the sale of
securities to investors
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•
The financial evolution created a very complex, opaque
structure of the financial system, with a long intermediation
chain involving an originate-to-distribute shadow banking
system. This system requires more transactions, more
counterparties, more market infrastructure, more demand for
collateral to support the transactions, and less complete
information about counterparties and their riskiness.
•
In this environment, risk exposures were more important and
harder to measure. There as a widespread high tolerance of
financial intermediaries, investors, borrowers towards risk
and a tendency to underestimate and underprice risk.
•
Systemic risk being procyclical, the broad tolerance for risk
supported the global business cycle and vice-versa.
•
Developments in the global financial system before the crisis
highlight the paradox of instability: the global financial
system looked strongest when it was most vulnerable.
•
In this environment, events in the real, financial or geopolitical sphere could easily act as triggers that could cause a
sudden unwinding of financial imbalances and lead to global
crisis.
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2. What are the key ingredients of macroprudential
policy, and how can it help prevent that systemic
financial crises will occur in the future with the
same magnitude as the global financial crisis?
•
Macroprudential policy can best be understood by contrasting
it with the traditional microprudential perspective on
regulation.
•
The micro and macroprudential perspectives differ in terms of
their objectives and understanding on the nature of risk. The
former aims at enhancing the safety and soundness of
individual financial institutions. The latter instead focuses on
the stability of the financial system as a whole, with a view to
limiting macroeconomic costs from financial distress. Another
key difference is that risk is taken as exogenous under the
microprudential perspective, while the macroprudential
perspective emphasizes the endogenous nature of systemic
risk.
•
Macroprudential policy therefore focuses on the procyclical
behavior of the financial system, and the interconnectedness
of individual financial institutions and markets, as well as
their common exposure to economic risk factors.
•
One important distinction is between tools geared towards
addressing the time dimension of financial stability – i.e. the
procyclicality in the financial system – and tools that focus on
the cross-sectional dimension – i.e. on how risk is distributed
at a point in time within the financial system and
contributions to systemic risk of individual institutions.
•
Macroprudential tools include countercyclical capital buffers,
liquidity tools (e.g. the net stable funding ratio), additional
buffers for systemically important complex financial
institutions, sectoral risk weights, loan-to-value ratios.
•
These tools have a twofold purpose:
•
o
smoothen the financial cycle, i.e. countering the
accumulation of financial imbalances over time.
o
Strengthen the resilience of the financial system
against unexpected shocks.
By addressing externalities in the financial system and
adverse incentives for excessive risk taking, macroprudential
policy can contributed to a safer financial system.
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•
By reducing the procyclicality in the financial system and the
scope of contagion, macroprudential policy attacks at the root
the problems that led to the global financial crisis.
•
Macroprudential policy is therefore a useful policy toolkit to
reduce the likelihood of future crisis and the magnitude of
crises should they occur.
•
At the same time, there are some potential limitations of
macroprudential policy.
o
We do not know where the next crisis will originate.
Regulatory arbitrage is notoriously an issue when new
types of regulation are introduced.
o
We still do not know their effectiveness, which depends
on a complex transmission mechanism.
o
Macroprudential tools might not be sufficiently flexible
to react promptly to the emergence of new risks in the
financial system.
o
There
are
important
governance
aspects:
macroprudential policy is carried out by central banks,
governments and other supervisory agencies.
o
There are potential leakages both in the domestic
system (given that macroprudential policy is geared
mostly towards banks) and across countries (as
systemically important banks are likely to operate on
an international scale).
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